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If you are watching any of the political debates happening at the current time, you'll know that the US deficits are forcing both parties to look into cutting the cost of entitlement programs, which means that the future of FDR's social safety net is more ambiguous than ever. We now saw the Social Security program snowball into a deficit a year ahead of projections and can safely say that post-baby-boomer generations-more than any group since the 1940s-will need to take greater personal responsibility for their own retirement. Below are a few options and quick descriptions of how each works. Please contact us if you'd like to discuss options for your specific situation in more detail.
In discussing retirement, it is important to remember that time is the most powerful tool on your side. To illustrate, do a Google search for "Compound Interest Calculator" and play with the results. If you are 25 years old and put away just $10 per week till retirement, earning an average 7% return on your investment, you will have $132,663.36 by age 67. If you start five years earlier, you would have $191,187.39. The extra $2600 saved turns into $58,524. This isn't to say that if you are over 25 it is too late to start, but that the sooner you start the better. As they say, there is no time like the present ... don't put off till tomorrow ... for less than a cup of coffee per day... [insert other personal affirmation here] ... remember, time-as of yet-is an unbeatable foe better befriended than ignored.
It is surprising that the current conversation about the possible privatization of Social Security has made little mention of a program currently in place to encourage individuals to save money for themselves. Beginning in 2002 the IRS has been offering a Retirement Savings Credit for lower income individuals. The credit can be 10%, 20%, or 50% of any retirement contribution made for the year, depending on your income and filing status.
For the self-employed, it is beneficial to note that this credit is based on income AFTER business expenses, meaning the better you track your expenses, the better chance you may also qualify for this credit. If you do qualify for the 50% credit, every dollar you put into retirement for yourself can save you 50 cents in tax. In other words, the IRS pays for half your retirement account. To follow the example above, with the 50% Retirement Savings Credit, the IRS doubles your investment, meaning your $10 per week becomes $20 and could grow to be almost $400,000 by the time you retire.1
Even if you do not have a job that offers a retirement account, there are numerous options available to you. Accounts are easily opened at any bank, brokerage, or online financial institution. Several types of accounts are available and each has different advantages and disadvantages. Choosing the right type of account can make a big difference in how much of your investment stays in your pocket and how much goes to the IRS. Below is a quick overview of the most popular options; however, as always it is advisable to speak with a professional if you are unsure what account is right for you.
All money put into a traditional Individual Retirement Account (IRA) is deductible from your taxable income in the year of contribution (subject to income and contribution limitations). This type of account is used to save money on your taxes now; however, any withdrawals from the account are considered taxable income. Plus, if you take money out before you reach retirement age, there is a 10% penalty added to your tax. This type of account is generally used by people who are closer to retirement age, have income in a higher tax bracket, and are confident that they will not need the money until they retire.
ROTH IRAs are a newer type of retirement option that function on the reverse theory of the Traditional IRA. Contributions are NOT tax deductible now; however, if you leave the money in the account until retirement age, all earnings are tax free. This makes the ROTH an attractive option for younger individuals who have a greater span of time for their investments to grow completely tax free. Another benefit of the ROTH is that early withdrawals (of previous contributions-NOT earnings) are not subject to the 10% penalty or tax, making the ROTH a more flexible (and available) type of investment.
Simplified Employee Pension (SEP) accounts are similar to Traditional IRAs but are available only to self-employed individuals or small businesses. Both SEP and Traditional IRA contributions are deducted from income now and taxable when withdrawn. The distinction is that a SEP has different contribution limits based on a percentage of business income rather than a fixed dollar amount. SEP contributions are limited to 25% of wages from your small business or 20% of your self employed income for the year (with a maximum of $53,000) vs. a Traditional IRA which is limited to $5,500. This makes a SEP a good choice for those with higher business income who want to contribute more than $5,500 per year to their retirement.
For more detailed information, please see the IRS Guide for Retirement Plans for Small Business.
One thing to keep in mind is that all of the above types of retirement accounts qualify for the Retirement Savings Credit. Plus each type of account allows contributions for the previous year to be made any time before the due date of your tax return (usually April 15th). What this means is that even if you haven't made a contribution to retirement yet, you still might be able to qualify for up to a 50% credit for the previous year. So when filing your taxes, always consider the potential effects of making a contribution to each type of account. It may be possible to file your taxes, claim the deduction and/or credit, get a substantially higher tax refund, and then use that refund money to fund the retirement account.
You could potentially let the IRS fund your retirement each year, but only if you take an active role and make informed decisions. My hope is that the above information helps you see that saving for your retirement is possible regardless of your current income. The only thing required is awareness and planning. Similar to what you heard years ago in cartoons about studying, knowledge really is power.
We at Fox Tax pride ourselves in being able to help our clients in both maximizing their current tax situation AND future financial security.2 Each situation is different and proper planning can be exponentially important. We would be happy to answer any specific questions you may have. Please feel free to contact us with any questions you may have.
1Example assumes qualification for 50% retirement savings credit each year.
2PERSONAL ANECDOTE: By advising one client to make $1,000 contribution to a retirement account, we were able to increase his tax refund by $1,200. Not only did the increase in his tax refund pay for his entire retirement contribution, but also put $200 extra dollars in the client's pocket! This isn't common, but is possible in the right situation and with the proper planning.